Automated Tax-Loss Harvesting by Wealthfront

Today, Wealthfront adds automated tax-loss harvesting to its suite of investment services, putting a benefit long used by the rich to reduce tax bills and maximize investment returns into the hands of typical Americans.

Our research shows that automated tax-loss harvesting would have increased your after-tax returns by an average of more than 1% a year between 2000 and 2011. Over the next 20 years that could add more than $54,000 on a $100,000 portfolio.

For more on how tax-loss harvesting works, here’s our video:

The Competitive Advantage

The wealthy have always had a competitive advantage when it comes to the U.S. tax code: They can afford to hire advisors to help them figure out how to pay only what they are required to pay. One of the services provided by those advisors is year-end tax-loss harvesting, which means selling securities trading at a loss at the end of the year so that a taxpayer can recognize the losses and write them off against other gains in her portfolio. Smart do-it-yourselfers follow a similar strategy, often selling a few losing securities at the end of the year to reduce their tax bills. Advisors and do-it-yourselfers do year-end harvesting because of the labor involved in selling losing securities and rebalancing a portfolio.

Wealthfront is automating this service and offering it for no additional fee to people with accounts of $100,000 or more. Because our method is software based, it is continuous rather than year-end based, which means the potential benefits are as much as double that of year-end harvesting. Take a look at the chart below to see what we mean.

How It Works

Wealthfront’s Tax-Loss Harvesting allows clients to write off harvested losses against capital gains generated elsewhere in their taxable portfolios. The harvested losses also can be applied against up to $3,000 worth of ordinary income each year, and losses in excess of $3,000 can be carried forward to write off against future income, too.

Because the securities sold are immediately replaced with similar, but not identical securities, the service will maintain the expected risk and return profiles of our clients’ portfolios. The money stays invested instead of going in an envelope to the IRS, potentially earning more in returns.

Democratizing Financial Management

The wealthy have long enjoyed the advantages of tax-loss harvesting. Most Americans, on the other hand, don’t have the wherewithal or the time to navigate the tax code, not to mention the money to hire someone to do it for them. Many don’t even file for the basic deductions to which they’re entitled: Less than a third of all the tax returns filed itemize any deductions at all, a far lower percentage than you would expect based on Americans’ 60%-plus home ownership rate and the large number who give money to charity (two of the most common deductions are for the interest on home mortgages and charitable contributions).

Automated tax-loss harvesting puts an important tool into the hands of people who otherwise would pay more in taxes than they needed to. In 2008-09, continuous tax-loss harvesting could have been particularly valuable to people who lost money in the market downturn.

What’s Different About The Software Approach

As we introduced the beta version of our service to clients in Silicon Valley, many asked, “Aren’t I just pushing my tax liabilities forward?” The answer is yes.

Because we almost immediately replace the securities you sell at a loss with other, similar, but not identical securities, you’ll likely see bigger gains on the replacement securities, and eventually pay taxes on them. But pushing tax liabilities into the future is a good thing: Because your harvested tax savings can be reinvested and compounded over time, you are almost always better off paying taxes later rather than sooner.

The Limits Of Democratization

While we can help you manage the taxes on your investments so that you don’t pay more than you are required to, we can’t change the actual tax code itself. For decades, regulations have kept Americans from writing off more than $3,000 of investment losses against their income. The number has not been adjusted for inflation, even as more Americans have invested greater amounts in the stock market – and, in some years, had major losses.

We can help you reap the benefits of tax-loss harvesting, but a full democratization of the financial system appears to be a long way off.

Disclosure

This blog was written in support of the marketing of Wealthfront’s investment products, as well as to explain its tax-loss harvesting strategy. This blog is not intended as tax advice, and Wealthfront does not represent in any manner that the tax consequences described herein will be obtained or that Wealthfront’s tax-loss harvesting strategy, or any of its products and/or services, will result in any particular tax consequence. The tax consequences of the tax-loss harvesting strategy and other strategies that Wealthfront may pursue are complex and uncertain and may be challenged by the IRS. This blog was not prepared to be used, and it cannot be used by any investor to avoid penalties or interest.

Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront and engaging in this tax strategy, based on their particular circumstances. Investors and their personal tax advisors are responsible for how the transactions conducted in an account are reported to the IRS or any other taxing authority on the investor’s personal tax returns. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction.

When Wealthfront says it replaces investments with “similar” investments as part of the tax-loss harvesting strategy, it is a reference to investments that are expected, but are not guaranteed, to perform similarly and that might lower an investor’s tax bill while maintaining a similar expected risk and return on the investor’s portfolio. Expected returns and risk characteristics are no guarantee of actual performance.

To achieve the projected return described here, we assume the Wealthfront portfolio with basic service has a risk score of 6.5, which results in a projected annual 4.78% return. This projected return does not take into consideration the effect of taxes, changing risk profiles, or future investment decisions. Commissions were considered. Projected returns do not represent actual accounts and may not reflect the effect of material economic and market factors. The projected return does not represent actual trading using client assets, but was achieved by means of forward-looking analysis. This projected return is not a guarantee of actual performance.

We simulated the potential after-tax benefit of our tax-loss harvesting service using historical results and found that it added an average of at least 1.03% annually, net of commissions. We used several assumptions to create one possible approximation, but did not rely on actual client trading history, and our results should not be relied upon for predicting future performance. The results are hypothetical only. These results are based on a study Wealthfront conducted for the years between January 2000 and December 2011, assuming a Wealthfront account with an initial deposit of $100,000, additional quarterly deposits of $10,000, and periodic rebalancing. Dividends and interest were not considered. Commissions were assumed to be $2 per security trade plus $0.0025 per share traded.

We assume the average 1.03% annual “tax alpha” from our simulation is reinvested back into the basic Wealthfront service portfolio to obtain a projected return of 5.81% (vs. the 4.78% projected return for the basic service). We compounded for twenty years the basic Wealthfront service portfolio and the Wealthfront portfolio with tax-loss harvesting both starting with $100,000. The estimated difference between the two portfolios at the end of the twenty years was $54,980.

To compare the possible benefit of continuous vs. annual year-end tax-loss harvesting, we use the same assumptions for the historical simulation for the years between January 2000 and December 2011 but with tax-loss harvesting opportunities examined daily vs. annually at year-end.

A different methodology may have resulted in different outcomes in either the simulated results or the projected returns. For example, we assume that an investor’s risk profile and target allocation would not have changed during the time periods shown; however, actual investors may have experienced changes to their allocation plan in response to changing suitability profiles and investment objectives. Furthermore, material economic and market factors that might have occurred during the time periods could have had an impact on decision-making. Actual investors on Wealthfront may experience different results from the results shown.

While the data used for its simulations are from sources that Wealthfront believes are reliable, the results represent Wealthfront’s opinion only. The return information uses or includes information compiled from third-party sources, including independent market quotations and index information. Wealthfront believes the third-party information comes from reliable sources, but Wealthfront does not guarantee the accuracy of the information and may receive incorrect information from third-party providers. Unless otherwise indicated, the information has been prepared by Wealthfront and has not been reviewed, compiled or audited by any independent third-party or public accountant. Wealthfront does not control the composition of the market indices or fund information used for its calculations, and a change in this information could affect the results shown.

Wealthfront may from time to time publish content in this blog and/or on this site that has been created by affiliated or unaffiliated contributors. These contributors may include Wealthfront employees, other financial advisors, third-party authors who are paid a fee by Wealthfront, or other parties. Unless otherwise noted, the content of such posts does not necessarily represent the actual views or opinions of Wealthfront or any of its officers, directors, or employees. The opinions expressed by guest bloggers and/or blog interviewees are strictly their own and do not necessarily represent those of Wealthfront. Nothing in this blog should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.